Thursday, November 11, 2010

Coincident with the promise of QE2 at Jackson Hole, Wyoming in late August has been the Fed's actions to maintain the balance sheet by reinvesting run off from QE1 mortgage back security maturations, back into the market via Treasury purchases. (using Permanent Open Market Operations) After the Fed stopped QE1 and before it began these POMO operations, the market acted far more normal left to its own devices, and indeed struggled from late spring to late summer. However, since the almost "every other day" purchases began via POMO, the market has staged yet another epic rally, mimicking various legs of the QE1 era.

While some of the credit for market gains due to POMO is most likely overdone, what is has done more importantly is created a change in psychology and expectation. To that end the "real economy" has not changed much from August 15th to October 15th, but the belief system of speculators has turned 180. Much like technical analysis, POMO has created a self reinforcing mechanism. I always tell people technical analysis only works because a mass of people think it will work. There is no reason for the 200 day moving average to be a relevant factor in stock purchases or sales; we have made it so. There is no reason for double tops, or triple bottoms, or MACD, or RSI, or Bollinger Bands, or any such things to have one iota of effect - but we have created the framework, and the more people who use it, the more powerful technical analysis becomes. It's a grand psychology experiment in many ways, and so goes the now almost religious "We can't lose due to POMO."

Yesterday's announcement of POMO just about every day in the coming month [Holy POMO!] and indeed by inference almost every day between now and June 30, 2011 (when one assumed QE3 will launch!) will cause issues with this psychology. I wrote 3-4 weeks ago it is going to take a change in market behavior on a POMO day for this religion of "we can't lose" due to POMO to fade away. Indeed it might take multiple days of blowups on POMO days. But the larger point is, when POMO was every other day (Mon, Wed, Fri one week and then Tue, Thu the next) you could still get some (mild) selloffs on non POMO days during the 'melt up rally', and the psychology of "bulletproof due to Ben" was still in place, because after all none of those reversions to the mean days were happening on the Fed's watch.

Now however, unless the market structure has completely changed and there will not be any material selloffs in the next 8 months, somewhere along the way people are going to get blown up on a POMO day. This is simply due to the fact that just about every day will now be a POMO day - so by the pure math of it, a material downward day has to fall on a POMO day. And that's where the mythic belief that it's nearly impossible to lose on a day the Fed is supporting the market begins to die. From there, the psychology changes and those who believe they are bulletproof have second thoughts.

Markets in the near term are very much psychological and confidence game theory - with many "bulls" now buying for no other reason other than "Ben has my back", seeing this tactic misfire will cause doubts on the veracity of their rationale. Therefore, while "awesome" on the surface, yesterday's announcement of POMO all day, every day will eventually backfire, and change the market psychology. It would have been far better for the Fed to continue the current farce (2 or 3 POMOs a week), which would allow selloffs to occur on non POMO days and speculators to front run the Fed "every other day" to keep the new world order intact.

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